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Op-Ed: The Next Crisis in Financials?


Common equity, risk will be key.

Editor's note: Mike O'Rourke is the chief market strategist at BTIG LLC, a premier institutional brokerage and fund services company.

As go the financials, so goes the market.

Year to date in 2009, the S&P 500 and the financials have traded in the same direction 65 out of 76 trading days, which is 85% of the time. Since the announcement of the Financial Stability Plan on February 10, it 's been 90% of the time; since March 10, it's been 100% of the time.

Needless to say, the rout in the financials late in the session likely took the broad market down with it. Financials dropped 4% in 25 minutes. The abrupt move in the final half hour of the session caught the market by surprise. The best explanation I found was a story from the morning edition of the Wall Street Journal, which has gained some traction; it said that "regulators used some estimates of likely losses on loans that were tougher than observers had expected."

During the day, CNBC reported that the banks will need to maintain a Tangible Common Equity (TCE) ratio of 3% under the "more adverse" scenario. They noted that it isn't finalized, and the risk weightings will come into play. Knowing TCE will be a factor in the stress test, I've noted in the past that the government has used Basel standards and Tier-1 capital for 2 decades, and it's a mistake to once again change the rules midstream.

TCE is the argument the bears in the financials have been making; therefore, the government felt the need to address those concerns. At first glance, the 3% TCE ratio appears tough, because the TCE ratio of many banks were already hovering below 3% at the end of 2008.

The Risk-Weighted Assets (RWA) that the TCE is measured against will be the key. For example, right now, Citigroup's (C) TCE is under 2%, but its TCE/RWA is 3% even prior to the conversion of the preferred. Citi expects its planned preferred exchange to increase TCE/RWA to between 5.4% and 8.1%, depending on participation.

Without the conversion, Citi is straddling the line and will have a tough time meeting the "more adverse" scenario without the preferred conversion.

For additional perspective on Citi's pre-crisis preferred TCE/RWA level, refer to Citi's first-quarter 2008 conference call, in which it said it would "keep our Tier-1 capital ratio above the 7.5% level and the TCE to risk-weighted managed assets ratio above the 6.5% level."

In this context, a TCE/RWA of 3% in the "more adverse" scenario is less than half of what you would expect in a healthy banking environment. When it comes to both Citigroup and Bank of America (BAC), the insurance protection that the government gave the firms in exchange for additional preferred shares lowers the risk weighting of the insured assets.
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No positions in stocks mentioned.

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